On the heels of the Fed announcement, we had a sharp rally in fixed income, sending interest rates on the 10-year note to a five-day closing low. Stocks also rallied on the announcement, suggesting that traders were greeting the moderate inflation scenario. But what happens going forward after sharp one-day drops in rates? Does that stoke further interest in stocks over the near term?
Going back to 2004 (N = 770 trading days), I found 124 occasions in which yields on the 10-year note declined by 1% or more in a single trading session (as was the case on Wednesday). Interestingly, two days later, the S&P 500 Index (SPY) was down by an average of -.02% (58 up, 66 down). That is certainly no bullish edge. By contrast, the remainder of the sample averages a two-day gain of .09% (352 up, 295 down). A one-day drop in rates does not appear to be bullish for stocks in the short run.
I then decided to divide the big interest rate drop days based upon the S&P 500 Index performance that day. Specifically, I wanted to see if returns were better following occasions in which stocks rallied on the interest rate drop vs. occasions when stocks dropped during the rate decline.
When rates dropped more than 1% in a day and stocks gained on the day (as was the case Wednesday; N = 63), the next two days in SPY averaged a loss of -.17% (25 up, 38 down). Conversely, when stocks fell on the rate drop (N = 61), the next two days in SPY averaged a gain of .13% (33 up, 28 down). In short, it appears that stocks might overreact to large interest rate moves in the short run. When stocks like falling rates (perhaps suggesting moderate inflation and possible Fed easing), they perform subnormally over the next two days. When stocks don't like falling rates (perhaps out of a concern re: economic weakness), they perform more normally.
My last look at the data compared days in which we made a five-day closing low in interest rates with all other days. When the rate on the ten-year note was at a five-day low (N = 214), the next two days in SPY averaged a loss of -.07% (102 up, 112 down). By comparison, the remainder of the sample averaged a two-day gain of .12% (307 up, 249 down). Once again, the falling rates, on a short term basis, are not associated with a bullish edge in the equities and, in fact, have led to a slight underperformance.
Note that over longer time frames--several weeks--I found that, across the rate spectrum, falling rates have been positive for stocks and rising rates in the 10 year note have led to subnormal returns. See also my analysis of stock returns and yields following Fed days for relevant data concerning near-term returns. Earlier in April, I noted that short-term market returns were not superior following short-term declines in rates. Since that time, the pattern has not changed. Of the 17 occasions since then in which we've had a large rate drop and a five-day low in 10-year yields, 8 have led to gains two days later and 9 have been followed by losses for an average loss in SPY of -.04%.
Perhaps the most important conclusion is that you can't generalize longer-term intermarket relationships to the market's short-term performance. While long-term falling rates are positive for stocks over the long run, the same relationship does not exist over short time horizons.